SOES Bandits

Q. On your “about us” page you mention the SOES bandits? Could you please tell me a little more about this? I’ve heard the term but not sure what it means.

In the mid 1980s, Nasdaq introduced the Small Order Execution System, or SOES. It was an electronic system designed to facilitate trading on low-volume stocks.

Prior to this system, market makers were busy concentrating and filling orders on their high-volume stocks such as Microsoft and Intel and may only check orders for the smaller, unknown stocks once or twice a day. If you placed an order for one of these little-known stocks, you may have to wait an entire day to find if it was filled or not.

To improve the speed of executions, Nasdaq required that any order for a stock programmed into the SOES system had to be honored by the firm or firms making a market in that stock. Market makers had to state how many shares they were willing to buy at the bid or sell at the asking price per customer order, which was called an auto-ex (automatic execution) limit.

For example, if a stock is bidding $30 and asking $31 and the auto-ex limit is 2,000 shares then the market maker must be willing to buy 2,000 shares for $30 and sell 2,000 for $31 for any customer order. The computer would automatically execute orders without any need for human monitoring whatsoever.

At the end of the day, market makers would receive reports showing how many shares they were net long or short for each ticker symbol. For example, the report may show the market maker purchased a total of 10,000 shares and sold 8,000 which means he’d have to buy 2,000 shares for the day.

While this seems risky, you must remember that the volume on SOES stocks was consistently low so market makers weren’t too concerned about the number of shares they were required to trade. The total dollar amount, comparatively speaking, was just too small to be a concern. Market makers just filled the orders according to the reports and were glad to not have to spend their time watching these stocks during the trading day.

While the SOES system freed up a lot of time and created a great financial efficiency, it also created a ruthless opportunity for an unscrupulous group of traders that later became known as the SOES bandits.

In order to understand how these traders ingeniously capitalized on a loophole in the auto-ex system there are two fundamental concepts you must understand. These concepts are the very reason their legendary idea worked.

Concept #1: Quote Price Must Reflect the Highest Bid and Lowest Offer
For any stock, you will always find a bid and ask price. The bid price is the highest price that someone is willing to pay. The asking price is the lowest price at which another is willing to sell.

In our previous example, we assumed the bid was $30 and the asking price was $31. This tells you that among all the limit orders entered from all the brokerage firms that the highest “buy limit” price is $30. At the same time, among all the orders, the lowest “sell limit” price was $31 as shown in the diagram below:

Because of these facts you,  as a retail investor, can currently buy the stock for the $31 asking price since that price is posted by a seller. You can also currently sell shares for the $30 bid price because that represents a buyer.

The important point to understand is that market makers must always reflect the highest bid or offer price. Continuing with the example, if you place an order to buy shares at a price between the bid and ask, say $30.20, then the quote must move to bid $30.20 and ask $31 if the market maker elects to not fill the order. The market maker must display your $30.20 buy limit since it is higher than the previous $30 limit.

If a new order to sell arrived at a limit price between these new bid and ask prices, it would reduce the asking price. For example, if another trader places a sell limit order for $30.50 and the market maker chooses to not fill the order, he must display the more favorable selling price. The new quote would be bid $30.20 and asking $30.50.

The important point to understand is that anytime any trader or investor places a limit order at a limit price between the bid and ask that it must be displayed if the order is not filled. This concept is what starts the ball rolling for the SOES bandits!

Concept #2: Low Volume Stocks have Wide Bid-Ask Spreads
The difference between the bid price and asking price is called the bid-ask spread. In our previous example, the stock was bidding $30 and asking $31, which means there is a one-dollar difference, or spread.

It is a well-known economic fact that stocks with lower volume have higher bid-ask spreads. Many traders believe this is the market maker “playing games” or trying to “squeeze out” extra money from the less active stocks. The fact is that the market – people like you and me trading – create the spread. The spread is simply a reflection of the volume. Lower volume stocks have higher spreads, while higher volume stocks have narrow spreads.

In order to understand why this relationship exists, you must understand some basic economics about prices. First, the higher that bid prices rise, the more that sellers are willing to come to the market. Higher prices entice traders and investors to place sell orders. Figure 1 shows this relationship:

Figure 1: Higher Bids Mean More Sellers Coming to Market

Figure 1 shows the volume along the horizontal axis with the stock price on the vertical axis. The chart just shows that as the bid price rises, so does the volume.

To read the chart, notice at the far left side of the scale, we see that at a price of $29.50 that 4,500 shares are traded. At the top of the Figure 1, a higher price of $30.50 generates a higher volume of 7,500.

This is another way of showing how the “supply” for a stock is created. If you want more supply, you (or the market maker) must bid the stock price higher. The higher the price, the more sellers will step in and deliver shares. The steepness of the line shows how sensitive sellers are to the rising price.

Of course, we can never be sure of the number of shares that will become available as the price continues to increase, but you just need to understand that the volume will increase as the bid price rises.

On the other hand, the lower the asking price falls the more buyers will come to market as shown in Figure 2:

Figure 2: Lower Asking Prices mean More Buyers Coming to Market

Figure 2 shows the “demand” side of the equation. As the asking price continues to fall, more and more buyers come to market in response to the lower price – just like shoppers when a department store announces a huge sale.

Figure 3 is an overlay of Figures 1and 2. You can see there is a point where these two supply and demand lines intersect. We know from basic economics that they must intersect at the market clearing price, which is shown to be a volume of 5,000 shares at a price of $30:

Figure 3: The Market Clearing Price is $30 with 5,000 Shares Traded

A market clearing price is the price where all investors who want to buy and sell at that price can do so. In our example, a price of $30 means that 5,000 shares will be purchased and sold. If the price were higher, we’d get more sellers than buyers. If the price were lower, we’d get more buyers than sellers. At a price of $30, there is an equal number of buyers and sellers and the market clears.

In the real world of stock prices though, we do not just have a single price. Instead, we have a bid price and an asking price; the spread between them tends to reduce the volume.

For instance, if the market maker charges a higher price for those willing to buy, say $30.10, and is willing to pay a lower price to those wishing to sell, say $29.90, we will get fewer buyers and sellers. However, because of this two-price system, we can find an equilibrium point at a reduced volume and the market can clear as shown by the red dotted line in Figure 4:

Figure 4: Bid-Ask Spread Creates Lower Volume

Notice that the introduction of a spread shifted our market clearing volume of 5,000 down to 4,900. Bid-ask spreads create three major inefficiencies in the market:

  • Buyers must pay more than the market clearing price ($30.10 in this example)
  • Sellers must receive less than the market clearing price ($29.90 in this example)
  • Less volume is created

To appreciate the brilliancy of the SOES bandits, you must understand that low-volume stocks have wide bid-ask spreads. Now that we have reviewed our two critical concepts, let’s see how the SOES bandits put them together to create a financial ATM machine.

The SOES Bandits
Once the SOES system was created, several astute traders thought about the rules. They realized that if all orders had to execute for the bid or ask and if the highest bid and offer had to be posted then a serious loophole resulted. Traders wanted to exploit the loophole but would require some “room” between the bid-ask spread in order for their scheme work well. Fortunately, the SOES system was designed for low volume stocks that come equipped with wide bid-ask spreads. And with that, the plan was hatched.

Here’s how it worked. Assume ABC stock had a three-dollar spread and was bidding $30 and asking $33. This big of a spread was not an uncommon for SOES stocks. Let’s also assume the auto-ex limit was 5,000 shares.

Two traders would get together, let’s say Alice and Zach, to act as a team, or should we say a pair of bandits. One moves the quotes; the other places trades.

Alice would start by placing an order to SELL 100 shares at a limit price less than the current asking price, say $31. It does not matter if she owns the shares or not because, as we will discover shortly, she will enter an order to buy them back in a matter of seconds.

Because the SOES system was designed to sell at the asking price or buy at the bid, her order will never fill. However, the price is better than the current $33 asking price so the quote would now move to a bid of $30 and an asking price of $31. Alice’s initial trade was nothing more than a red herring; it was done to trick the system to reduce the asking price. She has just moved the asking price down in order for Zach to execute a very favorable purchase price.

Zach now places a trade to BUY 5,000 shares, which is the auto-ex limit. In accordance with the rules, his order is automatically filled for $31 – no questions asked. Remember, the SOES system must sell at the asking price. He owes the broker 5,000 * $31 = $155,000 in three business days.

Of course, Alice’s order to sell 100 shares of stock is also filled at $31. The remaining 4,900 shares are the responsibility of the market maker who is completely unaware of the process that is unfolding. Because her order is filled and out of the way, the quote moves back to the original bid of $30 and asking price of $33.

Alice now places a trade to BUY 100 shares of ABC for a limit of $32. Again, the SOES system will not execute the order since it is not a limit at the current bid or ask. However, it must now change the quote to the more favorable bid that Alice has submitted. The quote is now bid $32 and ask $33. Alice’s order just raised the bid price for Zach to move in for the kill.

Zach now places an order to SELL 5,000 shares and is filled at $32. He receives $160,000 cash, which is more than enough to cover the $155,000 owed to the broker. He and Alice will keep the remaining $5,000. That $5,000 profit is a result of buying 5,000 shares for $31 and selling them for $32.

Alice’s order to buy 100 shares is filled as well. Alice has sold 100 shares for $31 and bought them back for $32, which is a $100 loss. She and Zach will share in the loss and split the remaining $4,900. Not bad for a day’s work considering the entire process took about ten seconds – quicker than the time spent to withdraw cash from an actual ATM machine.

Also keep in mind that the full dollar quotes used in the example were done just to make it easier to follow. In actual practice, Alice would probably enter an order to sell 100 just slightly above the bid, perhaps $30.10. This would give Zach a far more favorable purchase price of $30.10 rather than the $31 we used in the example. The same would be done for Alice’s buy order. She may enter a trade to buy 100 shares for $32.90 rather than the $32 we used as an example which gives Zach a more favorable selling price.

But even more enticing is that many of the SOES stocks had spreads much larger than three dollars that we assumed in this example. In the late 90s there was a stock called Spinnaker that had “class A” shares under the symbol SPNIA. It was not uncommon to see a quote of bid $30 asking $45 – a $15 spread! Imagine what the bandits could do with spreads that wide and auto-ex limits of 5,000 shares.

While Alice and Zach made a relatively big score in this example, you must remember that there were thousands of stocks on SOES. The pair of bandits would just move onto another stock and continue moving quotes and grabbing cash. Why wouldn’t they continue using the same stock over and over? The reason is that market makers had the right to reject multiple orders. That rule was implemented to prevent traders from “abusing” the system who, for example, may have wanted to purchase 20,000 shares. The rule prevented them from entering four trades of 5,000 shares and being guaranteed to receive the quoted asking price. Little did market makers know that an “abuse” like that would be the least of their worries!

What’s really interesting is that the slippery process used by the SOES bandits is not illegal; however, it was considered highly unethical. But bandits could not be jailed or fined in any way if they were caught. To put an end to the process, market makers created a new rule stating they reserved the right to change the auto-ex limits at any time. So just because your broker may tell you the auto-ex limit is 5,000 for a particular stock does not mean the market maker must honor it.

If a market maker felt he had been unfairly taken advantage of, he would just tell the broker that your order has been cancelled even though you may have received a report earlier in the day stating it was filled. And with that, the legendary SOES bandits packed up and got out of Dodge. The plug was pulled from the ATM machine.

In the “About Us” page on this website, I mention that a SOES bandit was disqualified from our team. The only reason he was caught was because his trading partner also had an account with us – a big mistake. We were able to match up the trades on the greenbar reports and could clearly see what was going on. Both traders were disqualified and required to close their accounts. But behind the bandit masks I sensed a slight smile. I’m sure they opened accounts elsewhere, having learned an invaluable lesson from their mistake, and continued on. The money was just too big to quit. At the time they were disqualified, the report showed that their loot for less than a month’s work stood at $70,000.

Albert Einstein once said that imagination is more important than knowledge. The SOES bandits are legendary proof that some of the best financial opportunities are reserved for the most creative. 

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